Permit me to issue and control the money of a nation, and I care not who makes its laws!

— Mayer Amschel Rothchild (1744-1812)

Central banks wield enormous influence over exchange rates, and currencies can unexpectedly dive or soar off of even minor policy shifts. That in turn can cause successful trades in other asset classes to unravel, as profits on stocks or bonds are eaten up by currency effects.

The Amsterdamse Wisselbank was founded in 1609 as a municipality-sponsored central bank. From 1655 it was based in the new Amsterdam city hall on the Dam Square – the current royal palace. Amsterdam created the Wisselbank to insulate foreign merchants from the debasement of domestic coins. According to Adam Smith, funds held at the Wisselbank were reputed to have an “intrinsic superiority to currency.”

The gold standard was characterized by the free flow of gold between individuals and countries, the maintenance of fixed values of national reserves in terms of gold and therefore each other, and the absence of an international coordinating organization. Together, as Eichengreen and Temin noted, these arrangements implied that there was an asymmetry between countries experiencing balance-of-payments deficits and surpluses. There was a penalty for running out of reserves, and being unable to maintain the fixed value of currency. But there was, aside from forgone interest, no penalty for accumulating gold. The adjustment mechanism for deficit countries was deflation rather than devaluation, i.e., a change in domestic prices instead of a change in the exchange rate. During the interwar years of 1920s and 1930s, it was widely believed that maintenance of the gold standard was the primary prerequisite for prosperity. The prevailing worldview was that a stable exchange implied a stable economy.

In such an environment, supplies of money and credit depended on the quantity of gold and foreign exchange convertible into gold in the hands of central banks. Indeed, a surfeit or scarcity of gold reserves drove the economic fortunes of nations during the interwar years. In the 1920s, the U.S. had become a gigantic sink for gold reserves and by the end of the decade had accumulated nearly 40% of the world’s gold reserves. In the run-up to the Great Depression, France had also increased its gold reserves at a rapid pace from 1927 to 1933. In contrast, UK and Germany never had reserves anywhere as large, and German gold reserves all but vanished in 1931.

All that glitters: It is a picture of ... penguins in Fort Knox!?

But there was only so much gold to go around. Soon the effects of asymmetry kicked in, and central banks jacked up interest rates in their desperate attempts to obtain more gold. This destabilized commercial banks, and depressed prices, production and employment. Subsequent bank closures disrupted the provision of credit to firms and households, forcing them to curtail production and cut consumption. Deflation amplified the burden of outstanding debt, forcing debtors to curtail spending still further in order to maintain their credit worthiness. As the gold-exchange standard collapsed into a pure gold-based system, economies were destabilized as never before.

What is most important to note here is that national policies had cross-border repercussions. For example, when the U.S. raised interest rates sharply in October 1931 to defend the dollar’s gold parity, it drained gold from other gold standard countries and ratcheted up the deflationary pressure on them. When France raised interest rates in 1933, it intensified the deflationary pressure on members of the gold bloc and triggered a race to the bottom. Had there been a way for countries to coordinate their actions, things might have turned out differently. As Eichengreen and Temin explained, while it was impossible for one country acting alone to cut interest rates to counter deflation, as it would cause gold losses and jeopardize gold convertibility, several countries acting in concert would have been able to do so. This is because loss of gold due to interest rate cuts by oneself would be offset by gain of gold due to interest rate cuts by all the others. But efforts to arrange this in 1933 went nowhere; as was often the case, domestic politics got in the way of international financial cooperation.

The 21st century analog – the euro – is not identical to the gold standard, according to Eichengreen and Temin, but the parallels are there. The euro did not simply follow the gold standard; it also followed the Bretton Woods System implemented after the Second World War. Both the gold standard and the euro are extreme forms of fixed exchange rates. Bounded by a common fate, the surplus as well as deficit countries are like inseparable Siamese twins; their actions have systemic reveberations throughout the euro zone, and the rest of the world beyond.

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